Risk is uncertainty pertaining to the current action which will come to foreground in the future and risk management is designed to counter that uncertainty. Risk management is the process by which various risk exposures are identified, reported, measured, mitigated, controlled and monitored. MOHAMMAD ASIF discusses the processes and models by which the Islamic finance industry manages and measures its own risk elements.
There are financial services such as Islamic fund management, Islamic structured products, Sukuk, etc., that have their own peculiarities and hence the risk management may be slightly different for these than for the conventional industry. The management of risk can involve using qualitative, quantitative or a mix of both models.
Risk management is a two-step process — determining what risks exist in an investment and then handling those risks in a way best-suited to your investment objectives. Risk management occurs everywhere in the financial world. Approaching financial risks, such as market, credit and operational uncertainties in a professional manner is becoming increasingly important.
Islamic finance and banking is fast becoming a competitive alternative to conventional banking around the world, and is not merely confined to Muslim nations. However, despite the fact that Islamic banking has well-grounded roots into the subsidiaries of the conventional banking system, there are many areas yet to be explored and developed in the risk management practices of Islamic finance and banking.
An interesting feature of Islamic finance — aside from (but related to) the need to remain Shariah compliant — is that risk and return are shared between the firm and its fund providers. In a conventional firm (which guarantees returns to its depositors and investors), only the institution bears the risk; no risk is transferred to the fund providers.
In theory an Islamic financial institution’s risks are lower than those faced by its conventional counterpart. But Islamic firms actually face additional and unique risks that may balance the scales. Conventional financial institutions are exposed to five broad types of risk: credit, market, liquidity, operation, and reputation. Islamic financial institutions face these risks, too, along with a slew of concerns that most conventional firms do not, such as equity investment risk, displaced commercial risk, rate of return risk, and Shariah non-compliance risk.
Restrictions established by Shariah law coupled with the young age of the Islamic financial industry, mean that these institutions can’t always mitigate their risks while their conventional counterparts can. The Islamic capital market is simply less developed compared to its conventional counterpart, which means that not many options exist (yet) to help Islamic firms mitigate liquidity risk.
The asset and liability sides of Islamic banks have unique risk characteristics. The Islamic banking model has evolved to one-tier Mudarabah with multiple investment tools. On the liability side of Islamic banks, saving and investment deposits take the form of profit-sharing investment accounts. The instruments on the asset side, using the profit-sharing principle to reward depositors, are a unique feature of Islamic banks. Such instruments change the nature of risks that Islamic banks face. Some of the key risks faced by Islamic banks are:
Credit risk — The loss of income arising as a result of the counterparty’s delay in payment on time or in full as contractually agreed;
Market risk — Can be systematic, arising from macro sources, or unsystematic, being assetor instrument-speciﬁc;
Liquidity risk – Arises from either difficulties in obtaining cash at reasonable cost from borrowings (funding liquidity risk) or sale of assets (asset liquidity risk);
Operational risk — The ‘risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events’;
Legal risks – Arise because a country’s legal systems do not have speciﬁc laws/statutes that support the unique features of Islamic ﬁnancial product;
Withdrawal risk — A variable rate of return on saving/investment deposits introduces uncertainty regarding the real value of deposits;
Fiduciary risk – Can be caused by breach of contract by the Islamic bank;
Displaced commercial risk – The transfer of the risk associated with deposits to equity holders;
Bundled risks — It is uncommon for the various risks to be bundled together. However, in the case of most Islamic modes of ﬁnance, more than one risk coexists.
Risk management practices in Islamic finance are very challenging as they cannot use financial derivatives to hedge their risks, which conventional banks are free to use. A loan loss in Islamic finance is considered a loss for the depositor, and not the bank itself under the profit and loss-sharing principle. In Islamic finance which works on the profit and loss-sharing principle, deposits are transferred into loan to borrowers, while in conventional banking, deposits are transformed into loans where the bank stands as the recourse guarantor for the loan deposits. This makes risk management substantially more challenging for Islamic banking.
A crucial question therefore arises. How do we modify existing derivatives in order to comply with Shariah? Answering this question would mean creating new instruments or risk management tools which follow the conventional system, but strike a balance by adhering to Shariah principles. As Islamic institutions continue developing innovative product lines to better compete in the global financial markets, risk management will only become more important.
The Prophet once asked a Bedouin who had left his camel untied: “Why do you not tie your camel?” The Bedouin answered “I put my trust in God”. The Prophet then said “Tie up your camel first then put your trust in God.” This is risk management!
Mohammad Asif is the director of JaZaa Financial Advisory. He can be contacted
at [email protected]